Economy in Review

A Funny Thing Happened on the Way to Recession

By The Dollars & Sense collective

A friend once told us that when he first took economics courses, he thought the constant discussion of “the Fed” referred to people who had enough to eat. He kept waiting to hear about “the Unfed.” If he had been starting economics this semester, he could easily have gone on to conclude that the Fed’s goal is to increase the ranks of the Unfed.

“The Fed” is the oft-used abbreviated name for the Federal Reserve System, which has the job of controlling the nation’s money supply and interest rates. On October 6 [1979], the Fed announced three major changes in its policies, changes which are likely to push the economy into a recession. The Fed’s action is the latest and strongest step in the government’s continuing effort to engineer a downturn.

Saturday Night Action

The Fed held an unusual Saturday night press conference to unveil its new policies. Late Friday until early Sunday in New York is the only time of the week when all the world’s main money markets are closed.

First, the Fed increased the “discount rate,” the interest rate it charges on the short-term loans it makes to private banks. This, in turn, would lead private banks to charge more on the loans they make.

Next, the Fed extended reserve requirements. Private banks are required to keep a specified fraction of their funds in non-interest-bearing reserve accounts with the Fed. By broadening the reserve requirement to include more types of funds, the Fed reduced the amount of new loans the banks could make (since a larger share of funds must be kept in reserves).

The discount rate and reserve requirement steps were designed to hold down the growth of borrowing and thereby limit business and consumer purchases. The third part of the Fed’s policy package was a switch in the primary way it regulates the amount of credit in the economy. In the past, the Fed has tried to regulate borrowing mainly through attempts to control the price of borrowing, the interest rate. Now the Fed will focus its efforts on directly controlling the amount of money—that is, the supply of funds available for borrowing. It has other means, besides reserve requirements, to limit this supply.

This new policy means that the Fed is abandoning its past practice of trying to prevent sharp ups and downs of interest rates. In the last year or so the Fed has tried and failed to bring credit under control through relatively small, gradual increases in interest rates. So now it’s taking a tougher, more direct approach to controlling credit—despite the risk of wide fluctuations in interest rates. Events in the weeks following October 6 have shown how the new Fed policies are affecting money markets. The money supply (according to the most widely used measure, known as M-1) fell by 1% in October, after having grown almost 1% a month earlier in the year. Interest rates shot up; the prime rate (the rate charged by big banks to major corporate borrowers), already at 13.5% before October 6, climbed two percentage points in the next few weeks, an unprecedented increase.

International speculators seemed to believe the Fed’s actions would have an impact on inflation. From October 5 to November 2, the dollar rose 2% in value against the mark and over 5% against the yen. The price of gold, which had been rapidly rising, fell by 3% during these weeks.

Why Not Prosperity?

The international response to the Fed’s action points to a major reason why the government wants a recession. For there have been at least three international economic problems confronting the United States.

First, since 1977 the growth of total output and income has been faster in the United States than in other developed countries (except Japan). A faster-growing economy has faster-growing imports; so U.S. imports have increased more rapidly than other countries’ purchases of U.S. exports. This leads to a decline in the value of the dollar.

Second, although the U.S. inflation rate is far from the world’s highest, it is higher than those in West Germany and the surrounding countries of northern Europe, a critical area in terms of trade competition. Moreover, the U.S. inflation rate has been one of the most dramatically accelerating in 1978 and 1979. U.S. inflation reduces what foreigners will pay for dollars (since what those dollars will buy is less) and makes foreigners less willing to hold dollars for fear of further inflation. This reduction in the demand for the dollar means a further decline in its value.

Third, as well as being the world’s biggest user of oil, the United States has been the slowest to cut back on oil consumption since the big price increases of 1973-74. When the United States recovery from the 1975 recession continued strong through 1977 and 1978, there was a new surge in oil use; and it was clear to both OPEC and the oil companies that the time was ripe for raising oil prices still further.

The combination of the falling value of the dollar and rising oil prices creates two sorts of difficulties. Most immediately, the U.S. must pay more in dollars for the goods from abroad, and this means more inflation. Also, because the dollar is so important for the international finance—multinational corporate traders hold accounts, in dollars, international banks make loans in dollars, many other countries tie the values of their currencies to the dollar—the decline of its value can mess up a lot of worldwide business.

Consequently, at an International Monetary Fund meeting in the week preceding October 6, European finance ministers pressured the Fed to take action that would push the economy toward recession. Such pressure was in line with what the government had been trying to do for at least a year and a half—cool inflation with a recession.

Recession is Washington’s answer to inflation. Throw enough people out of work, and there will be a lot less consumer spending. Eventually, businesses will not be able to raise their prices as rapidly and still make sales. Moreover, it’s easier for employers to stonewall against workers’ demands for higher wages when millions of unemployed are competing for the jobs. With a long enough recession, a decline in inflation is guaranteed—though with each passing recession the process seems to take longer and be more painful.

Recession relieves international troubles of the U.S., too; not only by reducing U.S. inflation, but also by reducing purchases of imports, including oil. When people are out of work and business are cutting back, no one buys much from abroad—and if you’re trying to boost the value of the dollar, that’s what you want.

The surprising thing about the coming recession is that it has been so slow to arrive. As early as the spring of 1978, the Administration began trying to slow down the economy through the time-honored remedies of budget cuts and “tight money.”

In mid-1978, CETA funds and federal aid to states and localities were cut back, a planned tax cut was cancelled, and most (non-military) departments of the federal government began spending less than Congress had appropriated for them. Also, with the economy growing, the government’s take from taxes was growing too. Thus, Carter has had some success in cutting the federal budget deficit.

A lower deficit means the government is spending less, or taking in more taxes (which reduces consumer and business spending). Eventually this should slow down economic growth. But it often takes a year or more for changes in the deficit to affect the level of production and employment.

The Fed got into the act, too—particularly after an ominous plunge in the value of the dollar in the fall of 1978. Fed officials made strong statements about their intention to raise interest rates and thereby curtail credit. At the end of 1978, a slump appeared imminent.

A False Start Downward

For the first half of this year, it looked good—if you like recessions. The growth of real output (real means corrected for inflation) slowed markedly in the first quarter of the year. Real output actually declined in the second quarter.

But this was a false start (or, more accurately, a false stop): renewed growth in the third quarter made up for the earlier slump. In retrospect, the decline in the second quarter may have simply reflected the gasoline shortages and the trucking strike—and the third quarter was a period of bouncing back from those interruptions.

Thus after more than a year of plugging for a recession, all that the government had achieved was a slowdown in growth. In the third quarter of this year, real gross national product was 1.7% higher than a year earlier, compared with 4.7% growth in the previous year. Employment, like production, showed no signs of declining; inflation rates continued to rise.

The reasons the economy has had such unexpected strength are connected to the unprecedented inflation, in two principal ways.

First, both businesses and consumers are frantically buying now because they expect prices to keep getting worse. Average consumer savings are down to an extremely low level, about 4.5% of income. Borrowing, especially by businesses but also by consumers, has been soaring.

In many industries, businesses have been borrowing to take on extra inventories, because they have expected that the price increases on those hoarded inventories would more than make up for the cost of borrowing. In the past, big build-ups of inventories meant that companies had produced more than they could sell and were therefore about to cut back; today they seem to have this meaning only in the auto industry.

Second, the economy has kept growing because the recent period has been a profitable one for business. Prices have been rising faster than wages, making labor look cheap to employers. But the slower growth of wages hasn’t held down sales, because companies and consumers have been borrowing and spending so fast to beat inflation. So in 1979, despite rising interest rates and decreasing stimulus from deficit spending, economic expansion has still been profitable.

An End to All That

The Fed’s October 6 actions are supposed to put an end to all that. Curtailing the money supply and pushing up interest rates will limit businesses’ growth by making it harder and more expensive for them to borrow, and by cutting back consumers’ ability to buy on credit.

Early hints of success were just starting to appear in mid-November. Retail sales dropped 2% in October, after several months of sharp increases. Commercial and industrial lonas on the books of major banks rose at an annual rate of only 7% in October, compared to 33% in September. Other forms of corporate borrowing also showed a sizeable slowdown.

But having been wrong a few months ago (when D&S, like almost everyone else, said the second quarter slump meant a recession was underway), we can’t yet be certain that the Fed’s new policies have pushed the economy over the brink. Nonetheless, if the Fed sticks to its stated intentions the recession should arrive soon.

U.S. capitalism has brought itself to an unpleasant impasse. If the government does not force the economy into recession now, the slump may come with much greater force a little later. If the inflation is not curtailed and the related international problems become serious, the situation could get entirely out of hand. International financial crisis, unpredictable political conflict at home, and even a general crash are all possible. The Administration and business would much prefer an earlier and possibly more manageable recession to a later and probably more dangerous one.

Sacrificing the President?

The one factor which might stop the government’s push for recession is the upcoming presidential election. In the past three election years, there has been a big spurt of expansionary government economic policy just before the voters whent to the polls. No one, after all, wants to go into an election being compared with Herbert Hoover. Better to have your recessions earlier in your term and then face the electorate with evidence that you’ve got things growing again.

Something like that was part of the Carter Administration’s original plan when they began trying to slow the economy down in 1978. A quick 1978-79 recession, or perhaps just a period of slow growth which could get the economy straightened out, and then the 1980 boom, triumphal reelection, four more years.

But events have not been kind to Jimmy Carter. Presiding over a paralyzed system, he has become the personal symbol of that paralysis. Having failed to make the economy behave as he wished, he may now have to give precedence to rescuing the dollar and slowing inflation, and give up the benefits of an election-year boom. Perhaps a new public relations firm could re-design Carter as “the President who saved us from ruinous inflation”—but only if he can do it next year without causing a full-scale depression.

More likely, Jimmy Carter will go the way of Gerald what’s-his-name four years earlier, defeated in part by the economic mess the country is in. But at least Carter can find a grim satisfaction in knowing that the job will be no easier for his successor.

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